Asia credit: Still a bright spot
- Valuations for Asia credit remain compelling. Yields in both the investment grade and high yield markets trade at a considerable premium to their US and Euro counterparts
- With the Chinese government letting more state owned enterprises (SOE) default this year and last, credit differentiation has been increasing in the onshore bond market and issuers with weaker fundamentals may see more challenges
- In the China offshore USD market, performance of investment grade and high yield bonds has been volatile due to a number of idiosyncratic credit events, which has meant that spreads have underperformed other markets. Nevertheless total returns have been competitive partly due to the low duration of this market
- The performance of the China property high yield market has seen some ups and downs this year, caused by headlines and credit events on certain property names. We continue to like the sector, on an individual selection basis, maintaining a preference for developers with high-quality land bank, strong sales execution and solid onshore funding sources
- The case for including Asia credit in global bond portfolios remains as strong as ever, with higher yields than other comparative markets, lower duration, diversification benefits, and low default rates
- The market will be watching out for risks in US inflation, likely US Fed tapering in 2022, and risks to economic recovery in countries in the region where Covid has surged again
Keeping (relatively) calm and carrying on
The Asia credit market has seen an eventful first half of the year, beginning with inflation concerns starting early in 2021, that in part led to a rapid rise in US Treasury yields. Asia is continuing to undergo an uneven economic recovery, with Covid resurgences in some parts of the region presenting near-term uncertainties for the affected economies. Concerns surrounding the financial situation of a mainland Chinese “Asset Management Company” (AMC) also turned up in April.
Despite some of the issues that have unfolded, Asia credit bonds have been relatively resilient, with the market down by 0.2 per cent year-to-date (as of 28 June), while global investment grade bonds fell by 3.1per cent. Fixed income asset classes have generally seen poorer performance versus equities in 1H 2021 in the midst of a “restoration phase” economic environment of strong growth and profits delivery, rising equity markets and higher bond yields.
The Asia USD high yield corporate market, which is up by 0.8 per cent year-to-date, has outperformed the Asia USD investment grade market, which has fallen by 0.8 per cent year-to-date. Asia investment grade credit was impacted by the 83bp rise in 10-year US Treasury yields in 1Q 2021 – with the market pricing in both inflation fears as well as a brighter economic outlook; 10-year US Treasury yields have fallen after reaching a peak on 31 March and is trading at 1.48 per cent (as of 28 June). Headlines surrounding a mainland Chinese AMC name initially dragged down the performance of China investment grade credit in the first half of April, while this segment has picked back up since.
Spreads in the Asia and US credit markets have tightened this year, though Asia credit still offers a substantial spread pick up versus US bonds; this is in spite of the much lower duration of Asia credit versus US credit (3.7 years lower for Asia investment grade credit compared to US investment grade credit). Strength in demand was also seen in the Asia credit primary issuance market while fund flows have demonstrated resilience.
Fig. 1: Year-to-date performance
31 December 2020 = 100
Source: Bloomberg; JP Morgan, BAML as of 28 June 2021.
US IG Corp – ICE BofA US Corporate Index; US HY Corp – ICE BofA US High Yield Index; Asia IG Corp – JP Morgan Asia Credit Corporate Index Investment Grade; Asia HY Corp – JP Morgan Asia Credit Corporate Index Noninvestment Grade; EM IG Corp – JP Morgan Corporate Emerging Markets Bond Broad Diversified Index High Grade; EM HY Corporate – JP Morgan Corporate Emerging Markets Bond Broad Diversified Index High Yield
At the most recent US Fed meeting in mid-June, rates were left at 0.00-0.25 per cent, with the Fed maintaining its guidance on the policy to keep rates unchanged until conditions are consistent with “maximum employment, and inflation has risen to 2 per cent and is on track to moderately exceed 2 per cent for some time”. Guidance on asset purchases was also maintained. However, the Fed now expects higher inflation for 2021, increasing its projection for PCE inflation to 3.4 per cent from the previous of 2.4 per cent estimate and forecasting core PCE inflation at 3.0 per cent, up from the previous 2.2 per cent estimate Thus, two rate hikes are forecasted for 2023, according to the FOMC members’ median expectation. As US inflation expectations have risen substantially since the start of the year, the upside to nominal Treasury yields is more likely to arise from the real, inflation-adjusted, component; the real yield remains well below equilibrium levels and should rise as the Fed moves towards reducing the current degree of policy accommodation.
In mainland China, policy normalisation, which had already begun last year, is expected to be gradual and flexible, while targeted support should continue. An abrupt policy turn is not expected, as authorities would continue to weigh policy trade-offs between economic growth and financial risks. Elsewhere in Asia, monetary policy is expected to continue to be supportive this year; while countries such as India and the Philippines are seeing more inflation challenges, we expect central banks to look through higher inflation due to the base effect and/or supply-side cost push, unless second round effects become evident on underlying inflation. In India, where inflation is expected to be higher than the 4 per cent mid-point target, the central bank will have to stay accommodative and rely on the government security purchase program to support range bound yields.
Amidst a higher inflation regime and a market environment where expected returns should be low for many liquid asset classes, the diversification properties of global government bonds are undermined. This points to a greater relevance for less expensive and more reliable diversifiers, such as Asian bonds, to serve as potential substitutes for global bonds in portfolios.
In mainland China and North Asian economies, the relative success in controlling and containing Covid-19 has meant less pronounced economic losses compared to other parts of the world. Asia generally benefitted from the strong export recovery in 2020, which was underpinned by tech/pharma demand and the relatively faster production normalisation. As a result, North Asian economies have already largely recovered, while mainland China's economy had, by the end of 2020, returned to the pre-Covid growth path. Economies such as India and Thailand, which have seen recent Covid resurgences, are being presented with near-term economic uncertainties; however, as vaccinations pick up, domestic demand and services should rebound in the second half and into 2022 in a favourable global demand environment.
Fig. 2: China: broad based cyclical recovery
China: select activity indicators (year-on-year %)
Source: Bloomberg, CEIC, HSBC Asset Management, May 2021.
In the beginning of the year, India was on the path to economic recovery, but new risks to recovery surfaced in April, when a ruthless second wave of Covid hit the country. Over the medium term, India’s economic growth outlook remains intact amid recent progress with land and labour reforms. Yet, India’s investment grade sovereign rating – currently rated BBB- with a stable outlook from S&P and Baa3 with a negative outlook from Moody’s – remains an overhang for Asia credit markets, as credit rating agencies keep an eye on the country’s credit metrics.
While recovery is facing short-term setbacks, particularly in emerging market Asia, recovery itself is not expected to be derailed. Growth outlook hinges on local virus situations, vaccination progress and policy trade offs, and we continue to expect uneven and divergent pace of recovery in the region. An overall sound economic situation in the region should continue to benefit Asia credit.
China’s increasing credit differentiation and impact on Asia credit
The mainland Chinese government has been allowing market forces to play a bigger role, as it reduces its level of support for troubled SOEs. We expect more idiosyncratic credit events as authorities continue on its credit clean up mode and as the country reallocates resources from debt heavy SOEs / local government financing vehicles (LGFVs) and zombie firms to the private sector. Some of the weaker and non-strategically important SOEs/LGFVs may be allowed to default, signaling to the market the need to raise overall credit standards and to contain the rapid growth of debt. However, we do not expect a broad based default scenario from these government-backed companies and the government is expected to contain any systemic risks; this is indicated partly from the issuance quota for local government special bonds – which has been set to be slightly higher than 2020’s quota, defying market expectations – as well as the so-called “window guidance” to banks to extend liquidity support. As this environment creates challenges for issuers with weaker fundamentals, credit differentiation has been increasing for China bonds, pointing to an increased importance for bottom up credit selection.
Within the offshore dollar space, the developments and financial concerns of a Chinese AMC and its dollar bonds have taken the spotlight since the beginning of April; at the moment, there is no clarity on the extent of support that would be granted from the government. This company is majority owned by the government and is one of four AMCs originally set up around 20 years ago to manage the bad debts carved out of the banking system. With the large size and high profile of this incident, the eventual government action may be representative of a “test case” in this new framework of increasingly allowing market forces to assess risk. The situation with this Chinese AMC has been in the headlines for over two months now. While initially, volatility in the Chinese AMC dragged down other China investment grade names – with higher quality names showing resilience while high beta names underperforming – some of these names have picked back up towards the end of April. Performance of China investment grade credit is flat since the beginning of April (as of 28 June).
Fig. 3: Performance of China USD IG bonds picked back up post volatility in April
JACI China IG TR Index
31 Mar 2021=100
Source: JPMorgan as of 9 June 2021. Investment involves risks. Past performance is not indicative of future performance.
In terms of credit ratings, most Chinese SOEs and financials in the offshore USD bond market enjoy two to four notches of rating uplift due to government support. However, in the medium term, we could expect credit rating agencies to potentially reduce the rating uplift especially for lower quality names, even though a widespread removal of the uplift is unlikely given the transition in China is gradual and the government will remain the backstop for strategically important issuers. Issuers with strong standalone credit fundamentals, regardless of local government support, and companies with strong refinancing ability might outperform.
For the China USD high yield bond market as a whole, the default rate stands at 2.4 per cent year-to-date, while the Asia USD high yield market’s default rate is at 1.7 per cent. 1The Asia high yield credit market is expected to see an overall low default rate in 2021, forecasted at 2.4 per cent for the year.1
Fig. 4: High yield corporate default rates (USD bond markets)
Source: JP Morgan report dated April 2021 for the China market and JPMorgan report dated June 2021 for the rest of the markets.
Note 1: Source is JPMorgan report as of June for the Asia high yield market and JPMorgan report as of April for the China offshore USD high yield bond market.
China property regulatory tightening
The performance of the China property high yield market has seen some ups and downs this year, caused by headlines and credit events on certain property names. The government is enforcing tightened measures for the property sector such as the “three red lines” policy, caps on sector related loans for banks, land sales restriction for local governments, stricter purchase restrictions and lower LTV ratios. Under the “three red lines” rule – which sets limits on bank borrowings, including a 70 per cent cap on developers’ liability to asset ratio, 100 per cent cap on net-debt ratio and a requirement that short term debt should not exceed cash – credit metrics have improved for Chinese developers with USD bonds; more than half of key Chinese developers with offshore bonds saw borrowings decline in the second half of 2020.
Despite regulatory tightening measures and some negative headlines, the overall sector remains well supported by fundamental resilience. We continue to expect greater credit divergence and maintain a preference for developers with high-quality land bank, strong sales execution and solid onshore funding sources; we believe these types of developers can better weather the regulatory tightening and should be able to benefit from the accelerated sector consolidation.
Fig. 5: Credit metrics for China developers improved under the “three red lines”
Number of developers
Developers are categorized on the limits breached under the three red lines policy, where if a developer scores green, no lines were breached and it has satisfied all three debt metrics; a developer scoring red indicated that all lines are breached, resulting in the developer unable to increase debt in the following year. The three debt metrics include liability to asset ratio, net debt to equity ratio, and cash to short term debt ratio. Source: HSBC Global Research as of June 2021. For illustrative purpose only.
Valuation argument remains intact
Valuations for Asia credit remain compelling. Yields of Asia USD investment grade corporate bonds have moved up by 26bp year-to-date (as of 28 June) and are currently trading at 3.3 per cent. This puts yields of Asia investment grade credit at a considerable premium versus US investment grade bonds, which trades at 2.1 per cent despite their higher yields year-to-date. Asia investment grade credit likewise trades at a premium versus Euro investment grade bonds and emerging markets investment grade credit. As the world’s bond markets still face an issue of negative rates – with one-fifth of global investment grade bonds trading at negative yields – Asian investment grade bonds’ potentially higher yields than bonds elsewhere is particularly appealing.
In the high yield market, the yield differential between Asia and the US is even wider, with Asia trading at a yield premium of 254bp over US high yield. A yield premium can also be found between Asia high yield versus Euro high yield and emerging market high yield credit.
Fig. 6: Yield comparison
Indices used: US IG Corp – ICE BofA US Corporate Index; US HY Corporate – ICE BofA US High Yield Index; Euro IG Corporate – ICE BofA Euro Corporate Index; Euro HY Corp – ICE BofA Euro High Yield Index; Asia IG Corp – JP Morgan Asia Credit Corporate Index Investment Grade; Asia HY Corp – JP Morgan Asia Credit Corporate Index Noninvestment Grade; EM IG Corp – JP Morgan Corporate Emerging Markets Bond Broad Diversified Index High Grade; EM HY Corp – JP Morgan Corporate Emerging Markets Bond Broad Diversified Index High Yield.
Source: JP Morgan, BAML, as of 28 June 2021. A positive yield does not imply a positive return.
In spread terms, Asia credit is trading wider than historical levels, particularly for the high yield market; Asia credit spreads are still trading at wider levels versus pre-COVID period, and there could be room for spread compression. Asia USD bonds are also running very short duration profiles, which adds to the asset class’ stability. The duration of Asia investment grade credit is 3.7 years below that of US investment grade bonds, while Asia high yield’s duration is 0.9 years below that of US high yield.
Fig. 7: Spreads
5-year average for spreads takes the average of daily spreads between June 2016 and June 2021. Indices used: US IG Corp – ICE BofA US Corporate Index; US HY Corporate – ICE BofA US High Yield Index; Asia IG Corp – ICE BofA Asian Dollar Investment Grade Corporate Index; Asia HY Corp – ICE BofA Asian Dollar High Yield Corporate Index; EM IG Corp – JP Morgan Corporate Emerging Markets Bond Broad Diversified Index High Grade; EM HY Corp – JP Morgan Corporate Emerging Markets Bond Broad Diversified Index High Yield.
Source: JP Morgan, BAML, 28 June 2021. A positive yield does not imply a positive return.
HSBC Asia credit strategy
The case for including Asia credit in global bond portfolios remains as strong as ever, with higher yields than other comparative markets, lower duration, diversification benefits, and low default rates. For our HSBC Asia credit strategy, we like select names within the mainland China property sector, despite a challenging first half of the year; we are expecting greater divergence in credit quality within the sector against a tightened policy environment. In India, we are overweight the utilities sector, favouring names with greater earnings stability. One of our preferred sectors in Indonesia is oil and gas given the cyclical and commodity recovery; elsewhere in Indonesia, we like quasi-sovereign names with a good yield pickup over sovereigns. The consumer sector should also benefit from an improving macro environment. We continue to like bank subordinated debt given their relatively defensive nature and attractive yields. In addition, we are looking at sectors and names that have been oversold but where fundamentals remain solid. Credit selection in our Asia credit strategy is critical and our strong credit research has helped us avoid poorly performing names.
Investment involves risks. Past performance is not indicative of future performance. Any forecast, projection or target contained in this presentation is for information purposes only and is not guaranteed in any way. HSBC Asset Management accepts no liability for any failure to meet such forecasts, projections or targets. The views expressed above were held at the time of preparation are subject to change without notice. The information provided does not constitute any investment recommendation in the above mentioned sectors, asset classes, indices or currencies. The information provided does not constitute any investment recommendation or advice. For illustrative purposes only.
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